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Business & Money

The utilities industry is in need of more equity.
Fortnightly Magazine - December 2004

50 percent common equity, 50 percent debt, and a beta of 0.70. Using the Hamada decomposition formula presented on page 30, if this company's common equity ratio went from 50 percent to 70 percent, its re-levered beta would decrease to 0.54 from the beginning 0.70 level-a decline of 0.16. In contrast, if this company's common equity ratio were to be lowered to 30 percent-a change in common equity ratio of 20 percentage points-its relevered beta would increase to 1.07-an increase of 0.37 from the beginning 0.70 level. Thus, changes in the cost of equity relating to changes in the common equity ratio are not symmetrical-something that regulators have to consider in evaluating capital structure decisions.

A second factor to be aware of is that many of the common methods used to estimate the cost of equity (e.g., discounted cash flow and capital asset pricing model) use market prices, either directly or indirectly, in their equity costing approaches. Since the price-book ratio for most utilities is well in excess of 1.0, this means that the financial leverage captured by these approaches may be less than the book-value-based leverage applied by regulators for setting rates. 4

Preferred Equity

There are two types of preferred stocks employed by utilities-"traditional" preferred stock and "trust" preferred securities. Trust-preferreds are a hybrid security comprised of a preferred stock and a debt security. The great majority of preferred stock outstanding for utilities is now of the trust-preferred type. Recent accounting changes call for deconsolidation of certain trust-preferred securities, but with the debt element being recorded on the balance sheet as part of long-term debt. In addition, what previously had been identified as preferred dividends from trust preferreds is now categorized as interest expense. Rating agencies, such as S&P, now include trust-preferred balances as part of total debt and trust-preferred "dividends" as part of interest expense that must be covered in the coverage ratios calculated. This transformation of most preferred securities into a near-debt equivalent is an additional reason why utilities have to thicken the common equity component of their capital structures.

Debt

Because utilities are both capital intensive and have an obligation to serve, it is important that they have investment-grade debt. Debt rated below that level often is regarded as having speculative characteristics and is accorded the sobriquet of "junk bonds." 5 While spreads between different ratings of investment-grade bonds are often in the 10-50 basis point range, the spread between the lower levels of investment grade debt and the higher levels of junk bonds are often in the 50-250 basis point range. Once a company is downrated to the junk level, it takes a long time to make its way back into investment-grade category.

There is a possible confounding effect when capital structure theory is applied to a regulated utility. For an unregulated firm, if the debt ratio is increased, the tax savings (flowing from the tax deductibility of interest payments) go to the common stock investors. For a regulated company, in contrast, the tax savings go to ratepayers. Thus, a lowering of the common equity ratio